Download Chapt12

Class Slides for EC 204
Spring 2006
To Accompany Chapter 12
The Small Open Economy
in the Short Run:
The Mundell-Fleming Model
Y = C(Y-T) + I(r) + G + NX(e)
M/P = L(r, Y)
r = r*
(IS)
(LM)
(Perfect Capital Mobility
and Small Country Assumption)
The Small Open Economy Under
Floating Exchange Rates
• Before analyzing effects of policies we need to specify the
international monetary system in which the country operates.
• Floating exchange rates characterize the system relevant for
most of today’s major economies.
• The exchange rate is allowed to move in response to changes in
economic conditions.
The Small Open Economy
Under Fixed Exchange Rates
• Central Bank stands ready to buy or sell foreign
currency at the fixed rate of exchange
• Bretton Woods System was fixed exchange rate system
• Gold Standard was a fixed exchange rate system
Interest Rate Differentials
r = r* + q
(Risk Premium)
Y = C(Y-T) + I(r* + q) + G + NX(e)
(IS*)
M/P = L(r* + q, Y)
(LM*)
q can represent either a risk premium and/or expected change
in the exchange rate
In Practice, Income Boom does
not occur following rise in risk
premium:
• Depreciation raises price of imported goods
and the price level
• Central Bank may try to avoid depreciation
by tightening monetary policy
• Increase in risk premium may directly cause
money demand to rise as people seek “safe”
asset
Foreign Exchange Market
Intervention
• In practice, governments intervene in foreign exchange
markets even under flexible exchange rates in order to
move the exchange rate in a desired direction
• Intervention is typically “sterilized” by the Central
Bank
• Central Bank “sterilizes” (offsets) the effect on the
domestic money supply arising from purchases/sales of
foreign currency
Sterilized Intervention
• A purchase (sale) of foreign currency would give rise
to an increase (decrease) in the domestic money
supply
• To “sterilize” this effect, the Central Bank uses an
offsetting open-market operation by selling (buying)
domestic Treasury securities, leaving the money
supply unchanged
• The small open economy model suggests that this will
have no effect on the exchange rate, since the money
supply is unchanged
Sterilized Intervention
• But, this sale (purchase) of domestic Treasury
securities by the Central Bank will increase (reduce)
the amount of Treasury securities held by the public
• The public may require a rise (decline) in the risk
premium on domestic securities in order to be willing
to hold the changed amount
• A change in the risk premium will shift the LM* and
IS* curves, leading to a change in the exchange rate,
even though the money supply is unchanged
Evidence on the Effectiveness of
Sterilized Intervention
• Very little evidence that intervention operates
through this “risk premium” channel
• Some evidence that intervention works by
signaling a future change in monetary policy
itself
• Accordingly, the exchange rate may adjust
today in response to this signal of a future shift
in monetary policy
The Mundell-Fleming Model
with a Changing Price Level
Y = C(Y-T) + I(r*) + G + NX(e)
(IS*)
M/P = L(r*, Y)
(LM*)
where we note the distinction between the real and nominal
exchange rates: e = e(P/P*)
The Large Open Economy
in the Short Run
Y = C(Y-T) + I(r) + G + NX(e)
M/P = L(r, Y)
NX(e) = CF(r)
Goods Market Eqm.
Money Market Eqm.
Balance of Payment Eqm.
(Net Capital Outflow = Net Exports)
The Large Open Economy
in the Short Run: IS-LM
Y = C(Y-T) + I(r) + G + CF(r)
M/P = L(r, Y)
(IS)
(LM)